From an analyst's point of view, cash flows from operation activities have two major drawbacks:

• CFO does not include charges for the use of long-lived assets. Recall that depreciation is added back to net income in arriving at CFO.
• CFO does not include cash outlays for replacing old equipment.

Free Cash Flow (FCF) is intended to measure the cash available to a company for discretionary uses after making all required cash outlays. It accounts for capital expenditures and dividend payments, which are essential to the ongoing nature of the business.

The basic definition is cash from operations less the amount of capital expenditures required to maintain the company's present productive capacity.

Free cash flow = CFO - capital expenditure

Free Cash Flow to the Firm (FCFF): Cash available to shareholders and bondholders after taxes, capital investment, and WC investment.

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv

• NI: Net income available to common shareholders. It is the company's earnings after interest, taxes and preferred dividends.

• NCC: Net non-cash charges. These represent depreciation and other non-cash charges minus non-cash gains. The add-back of net non-cash expenses is usually positive, because depreciation is a major part of total expenses for most companies.

• Int (1 - Tax rate): After-tax interest expense. Add this back to net income because:
  • FCFF is the cash flow available for distribution among all suppliers of capital, including debt-holders, and
  • Interest expense net of the related tax savings was deducted in arriving at net income.
  The add-back is after-tax, because the discount rate in the FCFF model (WACC) is also calculated on an after-tax basis.

• FCInv: Investment in fixed capital. It equals capital expenditures for PP&E minus sales of fixed assets.

• WCInv: Investment in working capital. It equals the increase in short-term operating assets net of operating liabilities.

Example

Quinton is evaluating Proust Company for 2014. Quinton has gathered the following information (in millions):

• Net income: $250
• Interest expense: $50
• Depreciation: $130
• Investment in working capital: $20
• Investment in fixed capital: $100
• Tax rate: 30%
• Net borrowing: $180
• Proust has launched a new product in the market. It has capitalized $200 as an intangible asset out of a product launch expense of $240.
• During the year, Proust has written down restructuring non-cash charges amounting to $30.
• The tax treatment of all non-cash items is the same as that of other items in the books. There are no differed taxes incurred.

Calculate the FCFF for Proust for the year.

Solution

NCC = Depreciation + non-cash restructuring charges - Cash expenses during the year in which they are capitalized = 130 + 30 - 200 = -$40 million

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv = 250 + (-40) + 50 (1 - 0.3) - 20 - 100 = $125 million

FCFF can also be computed from cash flow from operating activities (CFO).

FCFF = CFO + Int (1 - Tax rate) - FCInv

The convenience of this approach to calculation of FCFF is that CFO is already adjusted for non-cash charges and changes in working capital accounts.

Example

Uwe is doing a valuation of TechnoSchaft for fiscal year 2004, using the following information (in millions).

• CFO: $250
• Depreciation: $80
• Interest expense: $50
• Tax rate: 30%
• Investment in working capital: $60
• Investment in fixed capital: $240
• Net borrowing: $180

Calculate the FCFF for the company for the year.

Solution

FCFF = CFO + Int (1 - tax rate) - Investment in fixed capital = 250 + 50 (1 - 0.3) - 240 = $45 million

As CFO is given, information on WCInv and non-cash charges is not required.

Free Cash Flow to Equity (FCFE): Cash available to stockholders after payments to and inflows from bondholders. This is the cash flow from operations net of capital expenditures and debt payments (including both interest and repayment of principal).

FCFE = FCFF + Net borrowing - Int ( 1- Tax rate)

FCFE can be calculated from net income. Recall that FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv. Then:

FCFE = NI + NCC + Net borrowing - FCInv - WCInv

FCFE can be calculated from CFO.

FCFE = CFO + Net borrowing - FCInv

A positive FCFE implies that a company has more operating cash flow than it needs to cover capital expenditures and the repayment of debt. Therefore, such a company has cash available for distribution to shareholders.